Risk Managing an Evergreen Private Credit Portfolio

As the private credit market surges toward $3 trillion in assets¹, concerns are growing over the potential formation of a bubble—driven by too much capital chasing too few high-profile lending opportunities. Rather than focusing on whether the market is in a bubble, this article explores how to strategically manage risk within a private credit portfolio.

Key Highlights:

• Capital Concentration in Large Loans: Most capital inflows have targeted larger, private equity-sponsored businesses with EBITDA over $100M. This space is now highly efficient and saturated, characterized by tighter spreads, commoditized loans, and weakening loan terms—challenging risk-adjusted return potential.
• Potential Alpha in Inefficient Markets: Risk can be better managed by investing in less competitive, undercapitalized niches such as smaller borrowers, specialty lending, and asset-based finance. These areas can offer higher yields, better loan terms, and lower loan-to-value ratios due to reduced competition.
• Three Pillars of Risk Management:
  1. Diversification across segments, strategies, and issuers to mitigate volatility and avoid concentration risk.
  2. Credit Management through stringent underwriting, partner selection, and disciplined loan structuring.
  3. Liquidity Management using short-duration, laddered investments and cash-equivalent buffers to preserve flexibility and access.
• Not All Private Credit Is Created Equal: Like equities, the private credit market is heterogeneous. Opportunities vary dramatically by market segment, and risk-adjusted return potential is highest in those niches that are overlooked and underfunded.

Ultimately, prudent portfolio construction and active risk management—especially outside of crowded upper-market segments—are the keys to the opportunity for enhanced risk-adjusted returns from private credit investing in 2025 and beyond.

Risk Managing a Private Credit Portfolio in a Crowded Market

As private credit grows into a $3 trillion asset class, concerns over risk and overvaluation loom large. Yet, the solution isn’t avoiding private credit—it’s about managing it wisely.

Private credit refers to loans made by non-bank lenders directly to private businesses, a segment that expanded rapidly post-2008 as regulatory constraints limited bank lending. Today, the market faces a new challenge: excess capital flowing into a narrow segment of large, private equity-sponsored companies.

Where the Capital is Going

Most inflows have chased large borrowers—companies with EBITDA above $100 million and loan needs well into the hundreds of millions. This influx has commoditized that part of the market. With widespread competition, interest spreads have compressed, covenants have loosened, and lenders have taken on more risk to win deals.

• Borrowers under $100M remain underrepresented in terms of volume, even as total market deal flow grows.
• From 2015 to 2023, deal volume peaked around 2022, with notable share growth in $1B+ deals

In this highly efficient environment, outsized returns become harder to find. But does that mean all private credit is overvalued? Not at all.

Value Flows from the Forgotten Streams

The largest areas of the private lending market, much like the largest river systems, have been fully explored and mapped. These are the obvious, well-traveled channels of capital that are visible, deep, and widely pursued by institutional investors because it is familiar, liquid, and scalable. Yet there are thousands, if not millions, of smaller tributaries ripe for further exploration. While these areas are not always as obvious to the naked eye, proper exploration can identify undercapitalized and/or misunderstood lending niches that flow with potential. The overlooked corners of the private credit world—small businesses, niche lenders, and specialized asset-based finance—offer higher yields, tighter covenants, and better collateralization. These borrowers are often too small for large private credit firms and constrained by traditional bank lending standards.

• Heavy capital chasing large PE-sponsored loans (EBITDA > $100M, commoditized, covenant-light)
• Smaller, underserved lending niches with stronger protections and yield
  

For risk-conscious investors, this is fertile ground. Markets with fewer lenders and less capital create favorable dynamics: lenders can command better terms, reduce loan-to-value, and maintain underwriting discipline. These inefficiencies enable enhanced risk-adjusted returns without taking undue risk.

Risk Management Framework

The most effective way to manage risk in private credit is through a three-pronged strategy:

1. Diversification
   • Invest across multiple segments (e.g., real estate, legal finance, factoring, consumer finance).
   • Maintain limits on exposure per strategy or borrower.
   • Adjust position sizing to reduce downside risk in the event of a loss in any one segment.
2. Credit Management
   • Partner with lending specialists who focus on niche markets and have proven underwriting capabilities.
   • Look for strong collateral structures, tight loan terms, and stringent covenant enforcement.
   • Emphasize capital preservation over yield chasing.
3. Liquidity and Duration Management
   • Incorporate short-term private investments and liquid public assets to maintain flexibility.
   • Ladder maturities to provide periodic reinvestment opportunities.
   • Keep overall portfolio duration short to adapt quickly to changing market conditions.

Private Credit is not Monolithic

The phrase "private credit" encompasses a vast and varied universe. Treating it as a single asset class ignores the crucial differences across market segments. Just as one wouldn’t evaluate all equities through the lens of tech stocks, one shouldn’t judge private credit solely by the dynamics of large direct lending deals.

There’s opportunity in specialization—and risk in generalization.

Final Thought

Private credit remains a compelling tool for generating income and diversification. However, sustainable success requires strategic allocation, focused underwriting, and active management. In a market increasingly dominated by large players chasing the same deals, the real potential alpha lies off the beaten path.

In private credit, it pays to be selective. The optimal fishing holes are often the quietest ones.

For more information or to speak with a member of our team, please email info@lsfunds.com or click here.

Sourcing

• Private credit spans diverse sectors Heron Finance+15NAIC+15Citco+15Citco+1Calamos Investmentscommeketa.com+1Apollo+7PwC+7flow.db.com+7S&P Global.
• Direct lending is only part of the picture—specialty and niche strategies are significant NAICcom.
• Private credit has delivered relatively strong performance, particularly in volatile or rising-rate environments Heron Finance.
• There’s a divergence between crowded upper-market lending and less-saturated opportunities comalts.coMarketWatchwsj.com.
• ^¹Global AUM Growth: The asset class is estimated at $1.7 tn by late 2023 and forecast to exceed $3.5 tn by 2028. CFA Institute Daily Browse+5com+5Heron Finance+5
• ^¹2028 AUM Milestone: Moody’s predicts global private credit AUM will hit $3 tn by 2028, driven by factors like lower interest rates, declining defaults, especially in the U.S. and Europe. Moody's
• Bank Relationships:
  • Large U.S. banks’ lending commitments to private credit vehicles (BDCs, PD funds) surged from ~$8 bn in 2013 Q1 to ~$95 bn by 2024 Q4—a ~19.5% annualized growth. gov+2bostonfed.org+2
  • As of 2023, bank commitments to PE/PC fund sponsors reached ~$300 bn, or approximately 14% of their non‑bank financial institution lending—up from around 1% in 2013. org

Risks & Disclosures

Although niche and underserved segments of the private credit market may present attractive opportunities, investors should be mindful of the risks associated with these strategies. Key considerations include:

• Borrower Risk in Smaller Companies: Smaller and less established borrowers may have limited operating histories, narrower revenue bases, and fewer financing options, which can increase default risk.
• Specialty Lending Risk: Sectors such as legal finance, factoring, or consumer credit can be highly specialized and subject to unique regulatory, legal, or market developments that may affect performance.
• Collateral and Recovery Risk: While asset-based finance may provide additional security, collateral values can fluctuate and may be difficult to realize in adverse market conditions.
• Liquidity Constraints: Investments in niche private credit often lack secondary markets, making it difficult to sell or exit positions before maturity.
• Valuation Uncertainty: Limited transparency and reliance on manager estimates can lead to valuation challenges, particularly in undercapitalized or less efficient market segments.
• Macroeconomic Sensitivity: Rising interest rates, credit tightening, or economic downturns may disproportionately impact smaller borrowers and specialized lending strategies.

Investors should understand that these risks may result in the loss of principal, reduced income, or delays in expected cash flows. Niche private credit opportunities may complement a diversified portfolio, but they are not suitable for all investors.

Past performance is not indicative of, and does not guarantee, future results. Investors should carefully consider their individual circumstances and consult with a qualified financial professional before making any investment decision or adopting any strategy.

Diversification cannot ensure a profit or protect against principal loss. It is a strategy used to help mitigate risk.

This material is provided for informational purposes only and does not constitute investment advice, a recommendation, or an offer to buy or sell any security. All investments involve risk, including the possible loss of principal. Private credit investments are speculative, may be illiquid.

Past performance is not indicative of future results. Any projections, forecasts, or forward-looking statements are based on assumptions and current market conditions, which are subject to change without notice.

There is no guarantee that projections or forecasts will be realized. Statements regarding expected returns, yields, or outcomes should not be construed as guarantees of performance.

Comparisons to other asset classes or strategies are provided for illustrative purposes only and do not imply that such results will continue or be achieved. Market commentary is based on information believed to be reliable; however, accuracy and completeness cannot be guaranteed.

References to specific strategies or investments are provided for illustrative purposes and do not represent a recommendation. Indices referenced (if any) are unmanaged, cannot be invested in directly, and do not reflect fees or expenses.

Liquid Strategies, LLC (“Liquid”) is an independent investment adviser registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended. Registration as an investment adviser does not imply any specific level of skill or training. Additional information about Liquid, including our investment strategies, fees, and objectives, is available in our Form ADV Part 2A and our Form CRS.

All content is provided on an “as is” basis without warranties of any kind. While the information has been obtained from sources believed to be reliable, Liquid Strategies, LLC does not guarantee its accuracy or completeness, and it may be superseded by subsequent market events or other circumstances. We undertake no obligation to update or revise any information contained herein.

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